Turbulence ahead

The global credit crunch has hardly begun to bite: much worse is to come. Alex Brummer predicts that

There is a view at the Treasury that the government can ride out the global credit crunch in 2008 just as it navigated its way through the 1997-98 emerging markets crisis and the dotcom meltdown of 2001-2002, when its optimism prevailed over gloom-mongers in the City.

This time, I believe, things will be different. If the sub-prime crisis were the only problem that Alistair Darling had to confront, Britain might possibly muddle its way through the mess. However, the malaise is more broadly based. The public finances, which underpinned economic stability during Labour's decade in power, have become unhinged.

Globally, the twin threats of surging oil and food prices have rekindled the inflation threat. And after a long period in abeyance, the so-called global imbalances - the huge trade deficits of the Anglo-Saxon economies with Asia and the Gulf states - are unwinding. This threatens turbulence on the currency markets to match that in the wholesale money markets, where banks lend to each other.

There is also a political dimension. Throughout most of Labour's period in office, the Treasury, commanded by Gordon Brown, had a clear ride. Tony Blair only rarely entered the economic debate. That is no longer the case. The current Chancellor claims supremacy, but too often in recent months he has been second-guessed by No 10, where many of the Treasury's previous brightest stars now rule. This tension was visible last year when the first that No 11 knew of a retreat on capital gains tax reforms was from a leak to the Financial Times from next door.

Clearly, the impact of the credit crunch is far from over. Five months after the crisis began, the losses in the global banking system have still to be fully felt. So far an estimated $100bn of the $300bn of toxic sub-prime debt has been written down by banks across the world. There could be worse to come in the early months of 2008 as accounts are finalised.

The Bank of England's quarterly credit survey already shows a tightening of lending conditions. The housing bubble has started to deflate, with headline prices falling by 1.7 per cent in the last three months of 2007. Further sizeable declines in house prices can be expected, bringing increased job in security and reduced consumer spending. Job cuts have already begun in the financial services, and the construction sector is expected to follow. Businesses have begun to scale back investment plans as cash becomes ever tighter.

There are two well-established ways of dealing with slowdowns of the kind being seen in the credit markets. The classical monetary answer is to cut interest rates, a process the Bank of England started in December, when it reduced the base rate by a quarter-point to 5.5 per cent. The second, Keynesian approach is to expand the government sector.

Hands are tied

Both these paths face serious blockages. Most commentators expect interest rates to be cut dramatically in 2008 as the Bank's Monetary Policy Committee acts to head off recession. But will it do so at the risk of inflation? I doubt it. Yet the Bank has little control over external shocks such as the rise in global energy prices, triggered most recently by the assassination of Benazir Bhutto in Pakistan and tensions with Turkey in northern Iraq. Such events limit the capacity to deliver the kind of speedy rate cuts needed to head off a severe slowdown.

Similarly, the government has painted itself into a corner on the public finances. Tax revenues are sinking as a result of Britain's strong dependence on the damaged financial sector. Spending from April onwards will be severely constrained by the promise to hold public sector growth to 1.7 per cent (with the exception of health) and Darling told me, before the holiday break, that he is ready to say "no" to spending ministers. This comes against a background of rapidly rising borrowing. The budget deficit in the first eight months of the present fiscal year climbed to £36.2bn; the annual total is certain to exceed the £38bn borrowed in 2006-2007. So, unless the Chancellor is prepared to dispense with the fiscal rules that his predecessor put in place, he will be weaponless in the battle to avoid recession.

The last and remaining threat to stability this year is the pound. In the run-up to Christmas, Britons were celebrating sterling's surge against the dollar and the excitement of shopping trips to New York. But the UK's trade with the rest of the world is now deeply in the red and the pound, like the greenback to which it is so closely linked, is in retreat. As the global imbalances unwind it is quite possible that the Brown government could face the first sterling crisis since Britain was driven out of the Exchange Rate Mechanism in 1992.

All of this promises to test the mettle of policymakers in 2008. This would be a challenge for any confident, successful government, let alone one that has suffered so many batterings in the year it has just left behind.